Information in Balance Sheets for Future Stock Returns ...

Information in Balance Sheets for Future Stock Returns: Evidence

from Net Operating Assets *

Georgios Papanastasopoulos?

Department of Banking and Financial Management of the University of Piraeus

E-mail: papanast@unipi.gr

Dimitrios Thomakos

Department of Economics of the University of Peloponnese

E-mail: thomakos@uop.gr

Tao Wang

Department of Economics of the City University of New York

E-mail: tao.wang@qc.cuny.edu

First Draft: October 12, 2006

This Draft: April 25, 2009

*

The authors appreciate helpful comments from the seminar participants at the EAA (2007) annual

congress, at the FMA (2007) annual meeting, at the H.F.A.A. (2007) annual conference, at CASS

Business School, at HEC Lausanne and at the University of Piraeus. The authors also thank David

Hirshleifer, Gikas Hardouvelis, Roger Huang, Hoang Huy Nguyen (FMA discussant), M. Warachka

and an anonymous referee for insightful comments and suggestions. The usual disclaimer applies.

?

Corresponding Author

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Information in Balance Sheets for Future Stock Returns: Evidence from Net Operating Assets

Abstract: This paper extends the work of Hirshleifer et al. (2004) on the net operating assets

(NOA) anomaly. After controlling for total accruals, we find a negative relation of NOA and

asset NOA components with future stock returns. We also find that the hedge strategies on

NOA and asset NOA components generate abnormal returns and constitute statistical

arbitrage opportunities. Our overall analysis is highly suggesting that the NOA anomaly may

be present due to a combination of opportunistic earnings management with agency related

overinvestment.

Keywords: Net operating assets (NOA), stock returns, statistical arbitrage, opportunistic

earnings management, overinvestment.

JEL classification: M4

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Introduction

An extensive body of research in accounting and finance investigates the

informational content of firm¡¯s balance sheets for their future stock price returns. Starting

with Ou and Penman (1989) and followed by Holthausen and Larcker (1992), Lev and

Thiagarajan (1993), Abarbanell and Bushee (1997) and Piotroski (2000) they showed that

various balance sheet ratios can be used to predict future stock returns. Sloan (1996) found

that firms with low working capital accruals (change in net working capital minus

depreciation expense) experience higher future stock returns than firms with low working

capital accruals. Fairfield at al. (2003a) showed that changes in net long term operating assets

are associated with future stock returns in similar manner with working capital accruals. In

follow up research, Richardson et al. (2005) extended the definition of accruals employed in

Sloan (1996) to include changes in net long term operating assets and showed that this

extended measure of total accruals (change in net operating assets) is associated with even

greater stock returns. Chan et al. (2006) found that Sloan¡¯s (1996) results are primary

attributable to inventory, accounts receivable and accounts payable accruals. Finally, Cooper

et al. (2008) found that a firm¡¯s asset growth rate is also negatively related with future stock

returns, while Chan et al. (2008) showed that this finding exists for all asset growth

components except cash.

An important contribution to the above research is the paper of Hirshleifer et al.

(2004). They found that the level of net operating assets, scaled by lagged total assets (NOA),

is a strong negative predictor of future stock returns for at least three years after the balance

sheet information is released. NOA represents the cumulation over time of the difference

between operating income (accounting profitability) and free cash flow (cash profitability). In

other words NOA is a cumulative measure of total accruals ¨C a measure of balance sheet

bloat:

/ T = ¡Æ0 Operating Iincomet ? ¡Æ0 Free Cash Flows t = ¡Æ0 Total Accrualst

NOA

T

T

T

(1)

The key insight emerging from the above relationship is that a cumulation of

accounting income without a cumulation of free cash flows raises doubts about the

sustainability of current earnings performance. Hirshleifer et al. (2004) call the negative

relation of NOA with future stock returns as ¡°sustainability effect¡±, since high NOA is an

indicator of a rising trend in current accounting profitability that is unlikely to be sustained in

the future: investors with limited attention focusing in accounting income can make flawed

investment decisions.1 In particular, investors overvalue firms with high NOA and undervalue

1

Hirshleifer and Teoh (2003) suggest that information that is more salient or which requires less

cognitive power is used more by investors and as a result is impounded more in the stock prices.

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firms with low NOA. This leads to a NOA anomaly whereby firms with high (low) NOA

experience negative (positive) future abnormal stock returns. Hirshleifer et al. (2004) also

provided clear evidence that NOA is a more comprehensive measure of investor¡¯s overoptimism about the sustainability of current earnings performance that captures information

over and above than contained in working capital accruals and total accruals. Further, they

claimed that the level of net operating assets is superior to accruals because it captures all

cumulative past changes between accounting profitability and cash profitability, rather the

most recent change. 2

The current evidence on the predictive ability of NOA for future stock returns raises

several broader questions. First, previous research has not focused on the whether different

forms of net operating assets are related with future stock returns as measures of the

sustainability of current earnings performance. For example, as claimed by Hirshleifer at al.

(2004) an important distinction based on the nature of the underlying business activity that

NOA capture, is between net working capital assets (NWCA) and net non current operating

assets (NNCOA). Similarly, another important distinction based on the nature of underlying

benefits and obligations that NWCA and NNCOA represent, is between their asset and

liability components. In particular, NWCA can be divided into working capital assets (WCA)

and liabilities (WCL), while NNCOA into non current operating assets (NCOA) and liabilities

(NCOL).

Second, the interpretation of the NOA anomaly is still a controversial issue. Several

explanations can be put forward, but previous studies have not distinguished among them.

From a rational pricing perspective, a possible explanation is that high NOA firms are less

risky than low NOA firms, and therefore earn lower risk premia. As such, whether the NOA

anomaly represents rational risk premium or market inefficiency is under debate. Note that

based on Callen and Segal (2004) the NOA to equity market value ratio can be used to derive

an accounting-based valuation model with time-varying discount rates.

Under a behavioral interpretation, the most common line of thought follows the

opportunistic earnings management hypothesis of Xie (2001) and the agency related

overinvestment hypothesis of Jensen (1986). According, to the opportunistic earnings

management hypothesis, NOA increases as managers book sales prematurely, allocate more

2

In a recent paper, Richardson et al. (2006) argued that the predictive power of net operating assets

does not differ from that of total accruals because net operating assets in Hirshleifer et al. (2004) are

deflated by lagged total assets. Richardson et al. (2006) supported their argument with algebraic

decompositions and empirical results from descriptive statistics and correlations. However, note that

the measures used in Richardson et al. (2005) and Hirshleifer et al. (2004) are not mathematically

equivalent. Furthermore, empirical results from descriptive statistics and correlations do not necessarily

imply or infer causality for Richardson et al. (2006) argument. On the other hand, Hirshleifer et al.

(2004) findings show that the level of net operating assets is a cumulative measure of investor

misperceptions about the sustainability of financial performance that captures information beyond that

contained in flow variables such as working capital accruals or total accruals.

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overhead expenses to inventory than to cost of goods sold, capitalize operating expenses as

fixed assets, select depreciation/amortization schedules that are not based on the underlying

useful and salvage values of fixed assets and understate operating liabilities, in order to inflate

earnings upwards. Managerial discretion calls also for write-down decisions based on

subjective estimates of fair value of NOA (e.g. receivables, inventory, intangibles, property,

plant and equipment).

Based on the overinvestment explanation, NOA increases as managers invest in

value-destroying projects to serve their own interests. As another competing behavioral

explanation one can think that hypothesis that NOA contain adverse information about firm¡¯s

business conditions. Based, on this hypothesis, NOA could increase as a result of difficulties

in generating sales, pressures to extend credit terms, overproduction and less efficient use of

existing investments. In all above cases, high NOA provides a warning signal about the

sustainability of current earnings performance. However, investors with limited attention that

focus in accounting income and fail to discount for the low sustainability of current earnings

performance will overvalue (undervalue) firms with high (low) NOA.

A final behavioral interpretation could draw on the idea that the sustainability effect

may stem from the same patterns of investor behavior to the value/glamour effect.

Lakonishok et al. (1994) postulate that investors extrapolate the weak (strong) past growth

rates of value (growth) firms to form pessimistic (optimistic) expectations about their future

growth rates. As growth rates mean-revert in the future, investors are negatively (positively)

surprised by the performance of growth (value) firms. NOA by definition reflects all

cumulative past changes between accounting profitability and cash profitability, which in turn

tend to rise with sales. In other words, firms with high NOA are more likely to have high past

growth in sales. As a result, the sustainability effect may arise from investor¡¯s errors in

expectations about future growth.

The above behavioral hypotheses are not mutually exclusive and probably co-exist.

Managers of firms that face a slowdown in business conditions could have additional motives

to manipulate earnings upwards in order to meet analyst forecasts and to engage in wasteful

spending that serves their own interests, thereby leading to an increase in NOA. These

motives could be stronger as investors and analysts extrapolate past trends in growth rates to

form expectations about future growth rates.

The above issues motivate us to focus on the NOA anomaly in order to get a better

understanding of its underlying causes. Our work is organized along three dimensions. First,

we empirically investigate the relation of NOA and NOA components with future stock

returns ¨C after controlling for total accruals (TACC). That is, we examine directly whether

NOA and NOA components can reflect additional information for future stock returns beyond

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